Staying nimble and diversified: Capitalizing on income opportunities in 2025

Summary

Despite projections of a soft landing, the US economy remained resilient in 2024, driven by a strong consumer base, supportive fiscal policies, and business investments in areas such as artificial intelligence. While the US economy proved more resilient and exceeded economists’ expectations, there are potential downside risks to future growth.

Looking ahead to 2025:

• Favorable economic outlook, but potential downside risks exist: While we maintain a positive outlook on the US economy, significant policy uncertainty exists around tariffs, immigration, taxes, and government spending. Risks to economic growth include further weakening in the labor market, inflation staying elevated, and increased interest rates.  
• Select opportunities in equities: We expect earnings and dividend growth to be key drivers to equity markets in the year ahead. Excluding a small number of large-cap growth stocks that have led the narrow rally, equity market valuations look reasonable to us overall.
• Fixed income sector diversification: Within fixed income, we maintain a focus on current income and managing duration exposures around what may be a wide range for long-term interest rates. In contrast to corporate bonds, we are seeing opportunities within agency mortgage-backed securities (MBS) where spreads remain compelling relative to historical levels.

Franklin Income strategies strives to maintain a well-diversified portfolio, while having ample liquidity to take advantage of potential market dislocations. We remain focused on staying nimble to take advantage of potential increases in market volatility and the investment opportunities that may arise as a result.

The US economy remained resilient in 2024, but progress against inflation stalled somewhat

While there were some projections of a soft landing in 2024, the US economy continued to prove resilient driven by several factors including strong consumer spending, supportive fiscal policies, and business investments in artificial intelligence (AI). US consumers have benefited from solid growth in their disposable income and by a surge in household net worth, which reached a record US$169 trillion in the third quarter.¹ To this point, it appears that higher borrowing costs have had a muted effect on consumer finances overall as many consumers had locked in low rates from the prior years.

As was the case in 2023, disinflation in the United States continued in the first half of 2024. However, this momentum stalled somewhat in the second half with the latest core personal consumption expenditures (PCE) reading of 2.8%, well above the Federal Reserve’s (Fed’s) 2% target. By the middle of the year, the Fed’s secondary mandate to achieve maximum employment came into greater focus as concerns rose around growing weakness in the labor market. After a prolonged pause, the Fed cut interest rates by a full percentage point from September through December, reducing the fed funds rates to a range of 4.25%-4.5%. While we think that the Fed is likely to pursue further cuts in the year ahead, its approach will be cautious and data-dependent given the recent uptick in inflation and continued resilience of the US economy.

Navigating an uncertain environment ahead

As we look ahead, there are some potential downside risks that require careful monitoring. Risks include further weakness in the labor market, inflation staying elevated, and a higher-for-longer interest-rate environment. We expect some deceleration in the US economy with gross domestic product trending down toward its long-term growth rate of 1.5%-2%.

One of the bigger variables heading into 2025 is related to the second Trump Presidency and the impact of its potential policy initiatives. While policies that eventually get passed tend to be different than those proposed during the election campaigns, there is still significant uncertainty around tariffs, immigration policy, and fiscal deficits. Markets generally struggle with prolonged policy uncertainty, but efforts to reduce regulatory burdens have the potential to provide a tailwind to company earnings going forward.

Earnings and dividend growth to be key drivers of equity markets

We expect dividends and earnings growth to be the key drivers of equity markets in the year ahead as the opportunity for further multiple expansion may be limited. While the broader S&P 500 Index has delivered substantial gains over the past two years, the performance has been concentrated in a relatively small number of growth stocks that have an outsized weighting in the index. This is most clearly seen in the outperformance of the market-cap weighted S&P 500 Index versus the equal weighted S&P 500 Index, which returned 57.9% and 28.7% (cumulative), respectively. Over the same time period, the MSCI USA High Dividend Yield Index returned 19.3%.² After excluding a small number of mega-cap growth companies, equity market valuations appear reasonable to us overall as indicated by forward price-earnings (P/E) ratio of 16.5x for the equal-weighted S&P 500 Index.

Shifting fixed income landscape, focus on sector diversification  

Within fixed income, we are focused on current income and managing duration exposures around what may be a wide range for long-term interest rates. We may extend duration when the benchmark 10-year Treasury yield reaches around 4.75% and trim on rate rallies that push yields back toward 4%.

Credit spreads in both investment-grade and high-yield corporate bonds have tightened toward historical lows, leaving little room for further spread compression to contribute to total returns. In contrast, we find spreads in agency MBS still compelling compared to historical levels. This is a segment where we anticipate broadening our holdings to achieve fixed income sector diversification.